Fixed Annuity vs Index Annuity: Which Do You Need?
Securing steady, reliable income payments in retirement can be a big challenge. Fixed annuities and index annuities are two types of annuity contracts that can help provide reliable retirement income.
While their names are suspiciously similar, these two annuity products work very differently. A fixed annuity offers a guaranteed rate of return on your initial investment. An index annuity, meanwhile, may offer greater returns—in exchange for greater risk.
Here’s a closer look at both types to help you decide which you should choose for your retirement plan.
How Do Annuities Work?
An annuity is a contract between you and an insurance company or financial services firm. With an annuity, you’re investing money in an insurance product. In exchange, the insurance company guarantees that you will receive regular income payments over the course of a predetermined period of time in the future.
You can fund an annuity with a lump-sum payment or with smaller payments over time. The period when you’re contributing money to an annuity is referred to as the accumulation phase. When you begin to receive income payments, you’ve entered the distribution or payout phase.
As its name suggests, a fixed annuity provides a fixed rate of return, similar to a certificate of deposit (CD) or a bond. Index annuities and variable annuities give you exposure to financial markets and generate varying rates of return.
All annuities have annual management fees and what’s referred to as a surrender period, or a six-to-eight year period after you purchase the annuity when you can’t withdraw funds you’ve invested in the annuity without a penalty.
How Does a Fixed Annuity Work?
A fixed annuity gives you a set rate of return on the money you invest for a set period of time.
“Someone who desires principal guarantee and a guaranteed rate of interest would embrace a traditional fixed annuity,” says Mark Charnet, a certified financial fiduciary (CFF) with American Prosperity Group.
Fixed Annuity Rates
Similar to a CD or a bond, a fixed annuity gives investors a fixed rate of return on their funds. You’ll know what the rate of return will be before you ever purchase the annuity. Based on how much you invest, the insurance company will then use your lump-sum payment or projected total contribution to calculate the income payment you can expect to receive when you begin taking distributions.
Fixed annuities pay the same income payment at regular intervals for the entire duration of the payout period.
Fixed Annuity Benefits
For investors who want to preserve their savings and stretch them over their retirement years, fixed annuities offer several benefits:
Guaranteed rate of return. A predetermined rate of return means you won’t have to ride the stock market roller coaster.
Simple contract terms. Fixed annuities are the most straightforward of all annuity products. There aren’t many moving parts to decipher.
Improved budgeting. Because you know how much income you’ll receive from a fixed annuity, budgeting is easier.
Death benefits. Many fixed annuities come with death benefits, which means if you die before your funds are completely disbursed, you can pass those benefits on to a beneficiary.
Fixed annuities can also help you stretch a lump-sum payout from a pension plan. For example, if your spouse dies and you elect to receive a lump-sum payment from their pension, you can then invest that money into an immediate fixed annuity. That fixed annuity will then immediately generate regular monthly income payments for you at a set rate of return for a set number of years—just like the pension did.
Fixed Annuity Disadvantages
Even though they’re incredibly straightforward, fixed annuities do have their drawbacks.
Limited upside. When the stock market soars, you’ll still be locked into your contract’s set rate of return.
Inflation risks. Inflation can be unpredictable, and there’s no guarantee that your earnings from the fixed annuity rate will outpace inflation. Even with a cost of living rider (COLA), you might find that the cost of the rider negates any additional benefit it might offer. An inflation rider also means you’ll start with smaller distributions than you would otherwise.
The upside ends. The fixed rate on your annuity is only guaranteed for a certain number of years. You can re-up your contract, but the rate might not be as favorable as the rate when you initially signed up.
Essentially, the fixed rate is the most significant drawback of a fixed annuity. While rates tend to be higher than what you can get from a CD, they only last for a set period of time, and they may leave you exposed to an increased cost of living.
What Is an Index Annuity?
An index annuity, also known as a fixed index annuity or an indexed annuity, pays a fixed rate of return based on a specific financial market’s performance. Where a fixed annuity offers one guaranteed rate, an indexed annuity offers investors the potential to participate in some of the upsides of the stock market. If the markets perform well, you’ll make money. If the markets lose money, you’ll receive a fixed rate of return or no loss of your original investment instead.
Index Annuity Rates
There are a few important different rates to consider when evaluating index annuities: the rate of return of the index your annuity tracks, the participation rate, and the rate cap.
Say your indexed annuity tracks the S&P 500 with an 80% participation rate, meaning your investment is only eligible to earn up to 80% of the index’s total returns. If the S&P returns a total of 10% for the year, you’ll enjoy an 8% return on your investment. In your contract’s early years, it’s not uncommon to see high participation rates of 80% to 90%.
In subsequent years, however, participation rates usually decline.
Index annuities often have what are called rate caps. This means that your total annual rate of return is capped at a percentage. If your annuity has a 7% rate cap and, in the example above, your participation rate would have yielded 8%, you’ll still be capped at 7% gains for the year.
On the other hand, your losses are generally limited with an indexed annuity. If the stock market declines, you’ll instead earn a minimum guaranteed rate. For example, if the stock market loses 1% for the year and your guaranteed minimum rate is 2%, you’ll earn 2%. Guaranteed minimums typically range from 1-3% per year. Notably, this may not cover the entirety of the amount you hold in your annuity. Many fixed annuities will, however, have a stipulation that you won’t lose money, even if the market goes down.
Index Annuity Benefits
Fixed index annuities offer benefits for the right type of investor.
Potentially higher returns. Unlike a fixed annuity, there’s a chance to participate in the stock market’s upside to a degree.
Stability. With a guaranteed minimum rate, you’ll have a safety net.
Security. Your principal investment is generally secure.
And like all annuities, your investments will grow tax-deferred, and you’ll have a guaranteed income stream for retirement.
Index Annuity Disadvantages
While fixed index annuities offer some “guide rails” that protect your investment and give you the potential for upside, there are no guarantees of a higher return rate that justifies the annuity’s higher cost. Other disadvantages include:
Limited growth. You won’t benefit from the full return of the stock market in good market years due to participation rates and rate caps.
Surrender fees. If you need to tap your funds before the end of the surrender period, you could lose principal and have to pay a 10% early withdrawal penalty to the IRS.
Fluctuations. Your participation rate, rate cap and guaranteed rate can fluctuate every year, adding volatility to earnings.
Fixed index annuities have quite a few moving parts. You’ll want to be aware of every fee, rate and cap before you sign and how those features will change over time.
Which Is Best for You: Indexed Annuity or Fixed Annuity?
When it comes down to deciding whether a fixed annuity or a fixed index annuity is the better choice for your financial goals, the experts have tips to help you choose.
“A fixed annuity best suits a conservative investor who is not willing to risk having at least a certain portion of his or her nest egg in the market and wants a defined return for investment planning purposes,” says Sara Hornick, a fiduciary financial advisor with Hudson Wealth Management. “An example of when this type of account has worked well is when clients of mine wanted an additional $8,000 a year in income. They deposited $200,000 in a 4% fixed annuity, which allowed the interest to be taken each year.”
Those investors hoping to achieve some market growth might consider an index annuity, says Charnet of American Prosperity Group.
“An investor who would like to participate in the upside of the positive movement of a stock market index, yet have no participation when the return is negative, would appreciate the attributes of a fixed index annuity,” he says. “There are many different indexes to choose from, so shop around by company and product. Most offer the S&P 500.”
Whichever type of annuity you choose, Hornick has a final piece of advice.
“The first and most important question to ask is: ‘What is the purpose of this account?’ Is it for future income? To provide a death benefit? Safe growth? The answer should dictate the investment choice,” says Hornick.